Five Currency Hedging Questions Every LP Wants to Know…. and Every GP Should Be Able to Answer
Updated: Sep 14
With global asset pools under pressure and funds competing for a limited pool of capital, the service and delivery of your service is now as important for GPs as the opportunities themselves. With uncertainty riding high, investors are understandably cautious about parting with their cash, putting the onus on fund managers to manage their expectations and communicate value in a compelling and authoritative way.
In this changed environment, the usual proof points when raising a fund, such as investment pipelines, potential deals, and projected returns may not be enough on their own. When discussing opportunities in an increasingly globalized market, currency risk emerges as a crucial yet often overlooked facet of this equation, and one on which GPs need to be prepared to engage with investors.
Here we explore five currency hedging questions every LP wants to know and that every GP should be able to answer to close deals effectively.
Five Currency Hedging Questions Every LP Wants to Know
1. What is this going to cost?
While being an essential tool for mitigating investment risk, the realm of currency hedging introduces additional costs that demand thorough consideration in both planning and communication, including:
Transaction costs: The inherent fees associated with executing trades with the counterparties.
Hedging impact: The potential effect on returns due to the hedging itself from interest rate differentials
Collateral drag: The potential gains foregone when one hedges instead of keeping the position unhedged and not investing in the fund.
Quantifying, planning and mitigating these costs is highly dependent on the expertise and infrastructure within the firm itself, with legacy planning and modeling processes leading to higher costs to manage the hedged class.
2. What are the risks associated with hedging?
Transparent communication and trust building requires openness and clarity around not just the opportunities available, but also the potential downsides for investors. GPs should be able to assess and communicate potential issues around:
Liquidity Risk: Whether a counterparty can fulfil its obligations, especially during market turbulence.
Credit and Counterparty Risk: Consideration of the creditworthiness of counterparts, such as assessing the solidity of a bank or financing partner.
It’s worth noting that these are not fixed risks – GPs can, and should, attempt to reduce these as much as possible. This can include running robust analysis to measure liquidity and collateral risks, as well as working with the right FX providers, such as Tier-1 banks and Money Service Businesses (MSBs) to mitigate counterparty risk.
However, firms may lack the experience or tools to adequately address risk, especially across a broad portfolio of investments and timeframes. In these scenarios, working with a hedging partner can help build a fuller, more compelling picture of risk and reward for investors.
3. How will the hedged shares be monitored and communicated?
For long term investments, investors will expected regular updates on the performance and results of their shares, including:
Consolidation & Reporting: The mechanisms the GP will utilize to consolidate positions and the features of the share class reports.
Performance Updates: GPs need to chalk out a comprehensive plan detailing the frequency and medium of communication for regular performance updates, including how hedged shares perform against non-hedged classes.
Tracking and assessing the performance of large groups of shares can be time consuming, especially when working with manual processes. The more efficient and integrated the back end systems behind your hedge management processes, the more GPs can keep LPs in the loop and assured.
4. How much exposure will be hedged?
There is no specific number for a hedging ratio– the exact blend will depend on market conditions, investors' own risk tolerance and the time frame for the fund. The challenge for GPs is to take the lead and make a compelling case for the hedging strategy, including:
Target Ratio: Presenting an initial scenario based on market analyses and the target investor profile.
Hedging Strategies: Depending on the complexity of the fun, GPs might contemplate various hedging strategies. Some permit upside participation while effectively mitigating downside risks, while an active overlay hedging approach can often deliver the most cost-effective solutions. The feasibility of implementing multiple strategies may largely be determined by the operational expenses associated with planning and executing them.
At each stage of the process, GPs will need to be able to justify their decisions around hedging strategy to educate and reassure investors, with appropriate data and models, while also being receptive to investor feedback and updating strategies accordingly.
5. What are the potential operational challenges?
Along with the risks of hedging in the market come the internal challenges of delivering the service itself, including:
Documentation & Reporting: Identifying necessary changes to fund documents and reporting protocols.
Resource Strain: Hedging can be resource-intensive, demanding additional manpower or expertise.
Accounting & Tax Nuances: The hedge strategy chosen could necessitate distinct accounting procedures and trigger tax implications.
GPs should be able to demonstrate the capability to manage and execute every process associated with offering a hedged share class, whether internally or working with specialist partners.
Creating a Credible Hedging Strategy
In an especially dynamic market for fund management, hedging stands as both a shield and a sword. While it guards against unforeseen currency risks, it also carves out potential avenues for enhanced returns and competitive advantage.
This adds extra pressure on GPs, but also creates a new way to stand out in a crowded field. GPs, equipped with the right insights can create valuable, trust-driven relationships with LPs while also solidifying their position as informed, strategic decision-makers.